A Scare for the Web: Will Congress Let the Internet Tax Ban Expire?

About the Author

Unless Congress intervenes, this Halloween will be an especially
scary one for U.S. Internet users. At midnight on October 31, the
federal ban on Internet taxes expires, loosing state and local
governments to tax Internet services received by Americans. The
House of Representatives last week voted to extend the tax ban
another four years, but it refused to make the ban permanent. The
issue is now before the Senate. Since it was adopted nine years
ago, the Internet tax ban has proven to be sensible and successful.
Rather than let it expire, Congress should make the ban
permanent.

Background

The ban on Internet taxes was first imposed in 1998, when
Congress adopted a three-year moratorium on state and local
taxation of "Internet access." "Multiple" and "discriminatory"
taxes were also banned. The moratorium, with some modifications,
has been extended twice, in 2001 and 2004.[1]

The extent of the moratorium is often misunderstood. It does not
exempt Internet providers from most taxes of general applicability,
such as corporate income taxes or property taxes, and does not
exempt Internet sales from general state sales taxes, although the
collection of such taxes from out-of-state vendors is
problematic.[2] It does prohibit all taxes on Internet
access services--such as AOL accounts. Surcharges on Internet bills
like those often present on cell phone bills, for example, are
prohibited, as are "bit" taxes based on Internet usage. In
addition, any taxes that single out Internet services or
transactions for special or higher fees are also banned.[3]

On October 16, the House of Representatives approved
legislation, H.R. 3678, to once again extend the tax
moratorium--this time until 2011. The Senate is considering similar
legislation, and a group of Senators, including John Sununu (R-NH),
Ron Wyden (D-OR) and John McCain (R-AZ) have proposed legislation
(S. 156) to make the tax ban permanent.

Internet Growth

Since the moratorium first went into effect, the Internet has
expanded its reach beyond the imaginings of 1998, growing from a
promising new technology to an integral part of the U.S. economy
and American society. Nine years ago, fewer than 40 percent of
Americans were online, and "dial-up" service was virtually
everyone's sole means of accessing the Internet. Today, some
three-quarters Americans use the Internet, and close to half do so
through broadband connections--usually DSL lines or cable modems.[4] The
Internet has been a key driver of growth and productivity gains in
the national economy. And the economic benefits are matched by the
social benefits of the digital economy--in education, health care,
and civic participation.

Political Externalities

This success, however, would be threatened if state and local
tax collectors are allowed to target the Internet for taxation.
Many opponents of the Internet tax ban argue that it violates
principles of federalism; Washington, they say, should not second
guess state tax policy decisions.[5] But in this case, there is a
legitimate role for federal rules. The Internet, by its nature, is
an interstate--in fact, global--network. Bad policies in one state
are borne not just by that state's citizens, but by citizens of all
states, as well. This "political externality" can be direct--such
as taxes imposed on firms based predominantly out-of-state--or
indirect--such as slowing the growth of the Internet and decreasing
its benefits for the whole country. In such cases, federal
intervention is justified.

It is difficult, of course, to predict what kind or what levels
of taxes would be imposed if the federal ban expires. The revenues
currently collected by several states' "grandfathered" Internet
taxes are relatively small, comprising about 0.1 of the combined
tax revenue for the states involved.[6] But how high would the taxes
be if there were no federal limits? Based on taxes on other
communication services, it could be quite high. Wireless phone
subscribers, for example, pay almost 12 percent of their monthly
bill in taxes, and wire-line phone customers pay close to 17
percent.[7]

It is also difficult to predict what effect taxation of this
sort would have; much depends on the details of the tax plans
adopted. One particular concern, however, is the effect taxation
could have on subscribership to broadband services. While the
number of Americans subscribing to such services has been growing
rapidly, taxes on access could slow that growth--especially among
low-income consumers. With governments at all levels spending
millions to subsidize broadband access, and more subsidies being
proposed regularly, such a result would be perverse.

This does not mean that the Internet should receive preferential
tax treatment. Good tax policy should not favor any particular
industry or economic activity, no matter how important it may be.
But equally, policymakers should not target any sector with
disproportionately heavy taxes. In other words, the Internet need
not be taxed less than other parts of the economy, but it should
not be taxed more, either.[8]

The Need for Permanence

Congress should make the moratorium permanent, rather than
simply extending it once again. Requiring yet another renewal
debate in 2011, as provided in the House bill, would only lead to
uncertainty for Internet firms, consumers, and investors, limiting
the ability for access providers and customers to make long-term
plans and investments. There is little to be gained by requiring
Congress to review the ban again. In effect for nearly ten years,
the ban is hardly untested. Of course, Congress would, as always,
retain the power to change the terms of the moratorium, if
necessary.

The federal restriction on taxes on the Internet has proven
sensible and successful. Rather than let it expire, policymakers
should make it permanent.

James L.
Gattusois Senior Research Fellow in Regulatory Policy
in the Thomas A. Roe Institute for Economic Policy Studies at The
Heritage Foundation.

[2]An
interstate compact intended to address this problem has been
drafted but has not been agreed to by a sufficient number of states
to allow it to take effect. Any such compact would also have to be
approved by Congress. See Adam D. Thierer and Veronique de Rugy,
"The Internet Tax Solution: Tax Competition, Not Tax Collusion,"
Cato Institute Policy Analysis No. 494, October 23, 2003, at
www.cato.org/pubs/pas/pa494.pdf.

[3]Certain state and local taxes which were being
collected before the bans went into effect have been permitted to
continue under "grandfather" provisions in the law.

[7]These figures include taxes from all levels of
government. David Tuerck, Paul Bachman, Steven Titch, and John
Rutledge, "Taxes and Fees on Communication Services," Heartland
Institute Policy Study No. 113, June 2007, at www.heartland.org/Article.cfm?artId=21104.

[8]As
noted above, current law does not exempt the Internet from most
taxes of general applicability. However, all taxes on Internet
access service are banned, even if the tax in question applies
generally to all businesses. Thus, for instance, Internet access
services are exempt from general "gross receipts" taxes that may
apply to firms providing other types of services. The House
legislation would narrow this protection and allow such taxes if
certain conditions are met. The bill includes a requirement that
any such tax be imposed on a "broad range" of business activity and
that the tax not be "discriminatory to providers of communications
services." This seems reasonable. At the same time, there are
strong policy reasons why state tax officials should avoid gross
receipts taxes for any economic sector. See Patrick Fleenor and
Andrew Chamberlain, "Tax Pyramiding: The Economic Consequences of
Gross Receipts Taxes," Tax Foundation Special Report No.
147, December 4, 2006, at www.taxfoundation.org/news/show/2061.html.